Did the Lehman Failure Do It?

In contrast to the analysis of Lehman skeptics such as John Taylor (2008, 2009) and John Cochrane and Luigi Zingales (2009), the evidence we present supports the view of many practitioners that the decision not to rescue Lehman represented an immediate and massive shock to the financial system that was larger by an order of magnitude than anything seen over nearly two decades.

The evidence Sterling presents focuses on an index of daily financial conditions created by Michael Rosenberg for Bloomberg. The index drifted down in in the summer of 2008, then fell sharply from Lehman weekend until October 10, and then began a recovery. It returned to pre-Lehman levels earlier this year. The biggest three-day drop in the index occurred post-Lehman, which includes Reserve Primary "breaking the buck."

Sterling also produces evidence that the index of financial conditions is predictive of economic activity, which would show a connection between Wall Street and Main Street.

If you look at Sterling's analysis of how the market reacts to policy, it seems to me that general policy moves, such as providing protection for money market fund deposits, have more positive effect than bailouts. It would be interesting to go back and look at the Bear, Stearns bailout or the AIG bailout and see if they produced any positive result before arguing that a bailout of Lehman would have been a good idea.

Comments and Sharing

You can access the chart of the BFCIUS, at least, on Bloomberg's website if you want to look at older dates. You can get the value at any given day from the chart, but I'm not sure if there is an easy way to download the underlying data without a terminal.

A firm in crisis is forced by necessity to reveal more information about its past and prospective future earnings, and its portfolio to current and potential business partners. The firm's demise or survival does not remove the new information from the market.

The extra information allows the marketplace and counter-parties to reassess the value of all firms in the sector, all asset portfolios and the state of the economy. Once the information is out there in the market, the firm's outcome, survival or demise, does not remove or invalidate the information in the marketplace.

I do not think it is too difficult to make the case that it was the information about the state of Lehman's assets and earnings prospects that was the shock to the financial sector and the economy. Stepping in to bailout Lehman would have done very little, if anything, to preserve asset values, improve earnings prospects, and change the US economic outlook.

I was under the impression that failure to bailout Lehman did cause a panic, and why not? People discovered that risk wasn't being subsidised as much as they had thought -- the government was unexpectedly selective with its bailouts. The "rules of the banking game" had been changed by the failure to bailout Lehman, and people involved with firms exposed to similar risks to Lehman started getting worried.

The question should be: is this a situation worth preserving? It may have been stabilising in the short run to bailout Lehman, but in the long run it only encourages more reckless gambling with other peoples' money.

It seems to me the root cause of the risky investing goes back to 1998 and LTCM which did the same things Lehman and the others did, and it was bailed out by the other banks. Two years ago, the banks making the same bad bets were being bailed out by the other private banks, granted with help from their Fed credit line.

But then, you can blame it on JP Morgan who in 1907 bailed out the banking system personally, setting up the moral hazard of believing bankers can bailout the failing bankers without government.

But as Paulson got to be the sole head of Goldman because his co-leader committed Goldman to bailing out LTCM, an action that Paulson and his fellow partners objected to, I conclude that Paulson had sent mixed signals on the bankers bailing each other out. It seems like Paulson and Goldman in were looking for "them" to bailout the system by bailing out the failing banks so "we" Goldman can profit without kicking into the bailout kitty.

Lehman wasn't forced into bankruptcy because Paulson failed to act, but because the other private banks wouldn't bailout Lehman. And if Goldman was in as good a shape as they claim, Goldman should have stepped in and supported Lehman. If Goldman had committed itself, Warren might have as well.

If LTCM hadn't been bailed out by the banks, then we would have had a Lehman situation when the economy was strong, and regulation and resolution authority would have been in place by 2006.

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